Very Troubling – A Decline in the Audit Quality of Public Companies

By Gregory S. Dowell

Providing audit services to privately-held (non-publicly traded) businesses, nonprofits, and governments is a big part of the services we provide at Bass, Solomon & Dowell, LLP. This revenue source does not come without a significant cost to our firm – to insure our audit services are at the highest level, we invest a considerable amount of our resources into continuing education, internal staff training, internal review processes, and external peer review. The commitment for a CPA firm to provide audit services must be complete – you’re either in or you’re out, there is no middle ground.

It saddens me to see the recent headlines about the poor audit quality the Public Company Accounting Oversight Board has uncovered at all the major CPA firms and many CPA firms in the next tier. These huge firms have no reason to compromise quality and they should be leading our industry forward into the future. I can only suspect that greed, whether it is greed of money, clients, or professional exposure, must be getting in the way.

We can only build public trust in the financial statements if we, as auditors, do our job to examine the financials and provide an opinion as to whether the numbers are “right”. I thought we all learned lessons from the very public and damaging debacles at Enron and MCI Worldcom. Many of those problems occurred because of greed. Audits were relegated by CPA firms to the level of a commodity and were viewed as placeholders for the much more lucrative consulting engagements. We did not actively look for fraud, although every non-CPA in the world thought that our charge was exactly that – to look for fraud. Pre-Enron and MCI as now, the pricing of audits as commodity engagements by the Big Six, the Big Five, and the Big Four eventually trickles down to all firms that provide audits. As a profession, the big firms have led us directly into this mess before, and I fear that they are doing it again.

This is the recent article that appeard in The New York Times:

Bad Grades Are Rising for Auditors

Philip Scott Andrews/The New York Times

Published: August 23, 2012

Are audits getting worse? Or are the inspectors getting pickier?

Those would seem to be two possible explanations of a trend that looks very bad.

The names of the firms doing the audits were not disclosed, and many of them were very small firms, as opposed to the major firms that audit most public companies.

But the trends at the big firms are not promising either. They are subject to annual reviews by the board, but until 2009 those inspections did not disclose the proportion of audits reviewed that were deemed to be defective. Among the Big Four — Deloitte & Touche, PricewaterhouseCoopers, KPMG and Ernst & Young — the board found something wrong in nearly one in six audits it reviewed that year. A year later, the proportion had doubled to one in three. The 2011 inspections have yet to be released, so we don’t know if things got better or worse.

This is not strictly a Big Four problem. The next four firms, all much smaller but auditing a substantial number of public companies, scored a little worse.

Some of the reaction to the report on brokerage audits was harsh.

“If any other businesses, such as manufacturing or software companies, had such high failure rates in their products, they would go out of business,” said Lynn E. Turner, a former partner in Coopers & Lybrand, a predecessor of PricewaterhouseCoopers, and a former chief accountant for the Securities and Exchange Commission. He then referred to the Yugo, a car from the former Yugoslavia that gained a reputation for very poor quality, and that soon vanished from showrooms.

In fact, the comparison to car manufacturers helps to show why it is so hard for the market to sort out whether audits are done well. The quality of a car will become clear after it is driven for a while, and consumers will notice.

But if an auditor does no work at all and just signs on the dotted line before pocketing the fee, that fact may never become public. If the company’s books were actually pristine, so that a good audit would have uncovered no problems, nothing is likely to surface to demonstrate how bad the audit was, unless someone inspects the work that was done.

Given that reality, it seems amazing that the auditing industry was able to escape any real oversight until 2002, when the Sarbanes-Oxley Act established the accounting oversight board. Until then, the only reviews of auditing were “peer reviews,” administered by the American Institute of Certified Public Accountants, in which one firm checked up on another. Few problems were ever found.

The board began work in 2003, and fairly quickly found problems. In the first year of reviews, it noticed that one company had overstated its current assets, making it look better. It then checked other companies and found that the error was widespread, involving customers of each of the Big Four. A round of restatements followed.

The 2010 reports — the most recent available and the ones with the high level of deficient audits — concerned audits of 2009 financial statements. Inspectors focused on financial companies, and zeroed in on the willingness of auditors to accept valuations of complex securities without determining whether the valuation methods used were reasonable.

That year, 2009, was also the year that politicians put heavy pressure on the Financial Accounting Standards Board, which sets accounting rules, to relax rules on marking securities to market value. At a public hearing in March, Robert H. Herz, then the chairman of the standards board, was excoriated by members of the House of Representatives capital markets subcommittee for issuing rules that made the banks look worse than they deserved to look. FASB (pronounced FASS-bee) soon relaxed the rules, and auditors were expected to assure compliance with those newly eased rules.

Some accountants privately speculate that some of the lapses found by oversight board auditors could have been influenced by the pressure not to make banks, already in trouble, look worse than was necessary.

In its inspections of the audits of 23 brokerage firms, many of the auditing lapses found by the board dealt with the failure of the auditing firms to do enough work, at least in the inspector’s view, to justify a conclusion that the numbers were correct. In 15 of the 23 audits cited in this week’s report, “firms did not perform sufficient procedures to test the occurrence, accuracy and completeness of revenue.” In six of the nine audits where the auditor had to deal with how much securities were worth, “firms did not perform sufficient procedures to test the valuation.”

That is different from saying that the auditor reached the wrong conclusion.

In the 2010 inspection of PricewaterhouseCoopers, auditors were found to have missed significant errors in how one company accounted for derivative securities it owned. The board inspectors cited no other errors in financial statements, but in 27 of the PWC audits — out of 71 reviewed — the auditors failed to perform work that the board thought should have been done.

Those 71 audits were not chosen at random.

“Our approach is risk-based on two different bases,” Jay Hanson, the only board member with extensive experience in auditing public companies, said in an interview. He said the board sought out the riskiest clients at each firm, and then paid attention to what it knew about different offices of the firm. It might even choose to look at work done by a specific partner whose previous work had been deemed subpar.

“We are going into areas where we think there could be problems,” he said. Presumably a review of audits chosen randomly would find fewer problems.

The Big Four firm that has gotten the most negative reviews is Deloitte & Touche. Under the law, the accounting board does not disclose negative conclusions regarding a firm’s quality control systems unless the firm fails to address those problems within a year. Last fall, Deloitte became the only major firm that has had such a review released.

This summer, Deloitte gained another unfortunate distinction. The system of peer reviews still functions, with reviewers looking at audits of private companies that are not subject to review by the oversight board. Deloitte’s review, by Ernst & Young, concluded that the firm had not done enough work on some audits, and said that after the reviewers pointed out problems, Deloitte did more work and a client company had to restate its financial statements.

Deloitte received a grade of “pass with deficiency.” That had never before happened to a major firm.

Deloitte declined to discuss that review with me, but provided a statement saying, “Deloitte is proud of the significant investments and hard work we have put into raising the bar on audit quality and we are confident those efforts are having a positive impact. Audit quality has been and continues to be our No. 1 priority.”

It is hard to imagine any firm saying otherwise, which makes such assertions less than fully persuasive.

If there is not enough work being done, one cause may be time pressure. Audits must be done within 60 days of the end of a company’s fiscal year, and if a firm has not allocated enough staff to do everything needed, it faces the stark choice of not signing an audit report, which would devastate a client company’s stock price, or signing and hoping. It should come as no surprise that the first choice is seldom the one chosen.

Another cause could be money. Audit fees have been under pressure in recent years, as some companies show a willingness to change audit firms to save money. Doing more work for less is not a prescription for commercial success.

Oversight board officials say they are doing what they can to keep the firms from cutting corners. “We have some incredibly brutal discussions with C.E.O.’s of firms,” said Mr. Hanson. “We ask, ‘What are you doing to assure it is the margin that is being squeezed, that it is not the work that is being squeezed?’ ”

The firms, of course, say the work is not being compromised. Such claims will be easier to believe when board inspectors find the number of audit deficiencies is declining, not rising.